Defining Key Financial Ratios

Corresponding to figures from your financial statements, ratios make relationships in your business more understandable. A ratio is only a shorthand note: It shows you what's going on according to your books. If your books are accurate portrayals of your business, here are 10 checkpoints to think about.

Acid Test = Cash and Near Cash ÷ Current LiabilitiesMeasures ability to meet current debt, a stringent test since it discounts the value of inventories. The rule of thumb is 1-to-1. A lower ratio indicates illiquidity. A higher ratio may imply unused funds.

Current Ratio = Current Assets ÷ Current LiabilitiesAnother measure of ability to meet current obligations. Less accurate than the acid test for very near term, but probably better a measure for six months to a year out, since it contains receivables and inventories as well as cash and near cash. The rule of thumb is 2-to-1, though this will be affected by seasonality.

Receivables Turnover = Sales ÷ ReceivablesMeasures the effectiveness of credit and collection policies. If your ratio is going down, collection efforts may be improving, sales may be rising, or receivables are being reduced. If your ratio is going up, sales credit policies may be changing, collection efforts may be flagging, or sales may have taken a nosedive.

Caution: This ratio depends on when receivables are measured and the seasonality of the business. Careful bookkeeping is also essential. The same applies to inventory turnover: Make sure that the measures are comparable from month to month. Use average receivables (inventories) if you can.

Days Receivables = 30 ÷ Receivables TurnoverAnother way of looking at receivables. Particularly useful in explaining graphically what changes in credit and collection operations do to a business.

Inventory Turnover = Cost of Goods Sold ÷ Average InventoryA measure of how well inventory is managed. Most businesses have a steady inventory turn. Compare your figures from year to year, asking yourself what causes the inevitable fluctuations. Small fluctuations are probably due to the flow of work. If you produce one jumbo jet a year, your inventory picture will be very different from that of a dealer of ripe tomatoes.

Days Inventory = 30 ÷ Inventory TurnoverAnother way of monitoring inventory. This is controlled by your inventory ordering patterns (among other considerations), so be careful how you interpret it.

Gross Margin Rate = Gross Margin ÷ SalesPermits comparison of margins over months with dissimilar sales. Ideally, this holds pretty steady in good months and bad -- but it depends on your business. It can distort fluctuations if sales are erratic.

Net Profit Rate = Net Profit ÷ SalesAn overall batting average: The aim is consistency over the long haul, not just short-term stardom.

Return on Assets (ROA) = Net Profit ÷ Total AssetsA better profitability measure than ROI. ROA shows how well you're using your assets. However, since profits are a volatile short-term measure, this should also be taken with a grain of salt. The long-term trend is what matters. A large investment in fixed assets to handle growth will seriously alter this ratio.

All ratios must be taken in context. The reason to look at them on a monthly basis is to make sure that you spot trends as they develop, not afterward. If you are doing something exceedingly well, you need to know it. And if something is wrong, it's better to find out sooner than later.

This article was adapted from Chapter 11 of Financial Troubleshooting, by David H. Bangs Jr. and Michael Pellechia.